Stock options in divorce: assets or income?

• Author: Mard, Michael J.

Should stock options be classified as an asset for equitable distribution purposes in a divorce case or qualified as an income stream for alimony and child support purposes? As stock options become a central means of incentives for many executives around the country, this question has become crucial in divorce cases. As artfully and succinctly stated by Judge Altenbernd of the Second District Court of Appeal,

The difficulty with options in a dissolution proceeding is that they have a dual nature. They have characteristics of an asset in that they represent a right to purchase an ownership share in the underlying corporation's stock. Under some circumstances, they can be alienable. On the other hand, they have characteristics of income in that the whole purpose behind options is to allow the owner to capture the appreciation in value of the stock prior to its actual purchase. They are usually exercisable over time. Options are often designed to be exercised immediately, not held over the long term. Also, they are often given as a form of compensation. Complicating their nature even further, if an option is given as compensation, it can be deferred compensation for past services, compensation for present services, or compensation for future services.(1)

This article will discuss the arguments for both classifications and, like many things in life, conclude that the appropriate classification depends directly on the facts of the option and the relief the divorce court is attempting to achieve.

A Primer

The Chicago Board Options Exchange (CBOE) opened April 26, 1973, with only a few options trading on the Exchange. Today, there are over 1,900 underlying securities (or parent stocks) measured by 60 indices and measuring nearly 300 million option contracts traded. While options perhaps have the reputation of being reckless investments, 70 percent make money, with only 30 percent expiring worthless.

An option is a derivative security; it derives its value from an underlying stock. It is a contract for a right to buy (call) or sell (put) and, like most contracts, the value of the option depends directly on the terms of the option. Electing to buy or sell is called "exercising the option," which must be done before expiration date. If the underlying security is publicly traded, the option is public and has a specified expiration date which, for control purposes, is the third Friday of any one month. Most public options have an average life of about five months. If the underlying security is closely held, the expiration date would be stated in the contract.

Options are classified according to three types, all of which are a function of the ability to exercise the option. The American option can be exercised at any time; the European option can be exercised only at the expiration date; the Capped option can be exercised only during a specified period stated in the contract.

As the chart in the following exhibit shows, the values of calls and puts tend to rise and fall opposite each other as a function of the factors making up the option. This is true, except in two important circumstances: when the volatility of the underlying security increases or the time to maturity of the option increases. As either of these factors increase, the value of both the call and the put tend to increase.

Measurement of Stock Options

There are a number of models that can be used to value stock options but they all rely on the intrinsic value of the underlying stock and the time delay to exercise the option. Models can be broken into economic models or theoretical models. Under economic models, there is the Shelton model, which focuses on long-term warrants and empirical adjustment factors. The Kassouf model focuses on regression analysis. The theoretical models include the original BlackScholes model, originating in 1973 and modified by the Merton model, and the Noreen-Wolfson model. The Binomial model further supported these models in 1979. The BlackScholes model is most commonly accepted and widely used. It relies on the stock price, the exercise price, the risk-free rate, the time until maturity, and the volatility of the underlying stock. The Merton model assumed all the factors of BlackScholes and added a factor for dividends.

There are critical underlying assumptions to these theoretical models, including the following:

* The underlying stock is freely traded;

* The underlying stock has a constant variance rate of return;

* The underlying stock follows a random walk and is log normally distributed (efficient market);

* The option is European (exercised only at expiration);

* The investors can borrow and lend at risk-free rates;

* There are no outside factors (such as taxes, commissions...